Accounting Liquidity Ratios

What are the benefits of liquidity ratios?

The liquidity ratios measure the ability of a company to meet its short-term obligations, say in the next 12 months. If a company does not have sufficient liquidity, it may be necessary to analyse whether it would be able to remain solvent and continue in operation in the longer term.

It may be useful to compare the liquidity ratios with the previous period end to see if it is improving or worsening. It may also be compared to similar companies in the industry. If the current assets of a company are less than the current liabilities. it may not be able to meet its short-term obligations unless additional funds are raised.

What is the Current Ratio, and how is it calculated?

The Current Ratio is calculated by dividing the total current assets by the total current liabilities. It shows whether the cash balance and the assets which are convertible to cash in the next 12 months are sufficient to meet the obligations in the next 12 months.

Current ratio = Current assets / Current liabilities

What is the Quick Ratio, and how do we calculate its value?

The Quick Ratio which is also referred to as the Acid-Test Ratio shows to what extent the company is capable of paying off the short-term obligations with assets that are easily convertible to cash. In this ratio, the inventories value is deducted from the current assets, and the resulting amount is divided by the current liabilities. If a company has inventories, the quick ratio will always be lower than the current ratio.

Quick ratio = (Current assets – Inventories) / Current liabilities

What is the Cash Ratio, and how do we calculate it?

The Cash Ratio shows the extent to which the company is able to service the short-term obligations with cash and cash equivalents.

Cash ratio = Cash and cash equivalents / Current liabilities